The Theory of the Firm

factors of production classified as:
Land – all natural resources of

the earth – not just ‘terra firma’!
Price paid to acquire land = Rent
Labour – all physical and mental human effort involved in production
Price paid to labour = Wages
Capital – buildings, machinery and equipment not used for its own sake but for the contribution it makes to production
Price paid for capital = Interest

one factor fixed in supply but all other factors capable

of being changed
Reflects ways in which firms respond to changes in output (demand)
Can increase or decrease output using more or less of some factors but some likely to be easier to change than others
Increase in total capacity only possible in the long run

firms can increase labour and capital but only up to

a certain level – they will be limited by the amount of space. In this example, land is the fixed factor which cannot be altered in the short run.

can reduce its variable factors – in this example it

reduces its labour and capital but again, land is the factor which stays fixed.

can reduce its variable factors – in this example, it

reduces its labour and capital but again, land is the factor which stays fixed.

as the period of time taken to vary all factors

of production
By doing this, the firm is able to increase its total capacity – not just short term capacity
Associated with a change in the scale of production
The period of time varies according to the firm and the industry
In electricity supply, the time taken to build new capacity could be many years; for a market stall holder, the ‘long run’ could be as little as a few weeks or months!

can change all its factors of production thus increasing its

total capacity. In this example it has doubled its capacity.

La)
Output (Q) is dependent upon the amount of capital (K),

Land (L) and Labour (La) used

classified as:
Fixed costs – costs that are not related directly

to production – rent, rates, insurance costs, admin costs. They can change but not in relation to output
Variable Costs – costs directly related to variations in output. Raw materials primarily

production
TC = FC + VC
Average Cost – the cost per

unit of output
AC = TC/Output
Marginal Cost – the cost of one more or one fewer units of production
MC = TCn – TCn-1 units

quantities of variable factors to a fixed factor
Long run –

Increases in capacity can lead to increasing, decreasing or constant returns to scale

given output
TR = P x Q
Average Revenue – the average

amount received from selling each unit
AR = TR / Q
Marginal revenue – the amount received from selling one extra unit of output
MR = TRn – TR n-1 units

the process of directing resources to alternative uses in free

markets
Relating price to costs helps a firm to assess profitability in production

firm in its current line of production
Abnormal or Supernormal profit

– profit made over and above normal profit
Abnormal profit may exist in situations where firms have market power
Abnormal profits may indicate the existence of welfare losses
Could be taxed away without altering resource allocation

the market even if sub-normal profits made if they are

able to cover variable costs
Cost of exit may be high
Sub-normal profit may be temporary (or perceived as such!)

true – there are other objectives
Profit maximising output would be

where MC = MR

of producing one more unit of output – the price

received from selling that extra unit.

MC

MC – The cost of producing ONE extra unit of production

100

Assume output is at 100 units. The MC of producing the 100th unit is 20.
The MR received from selling that 100th unit is 150. The firm can add the difference of the cost and the revenue received from that 100th unit to profit (130)

20

150

If the firm decides to produce one more unit – the 101st – the addition to total cost is now 18, the addition to total revenue is 140 – the firm will add 128 to profit. – it is worth expanding output.

101

18

140

30

120

The process continues for each successive unit produced. Provided the MC is less than the MR it will be worth expanding output as the difference between the two is ADDED to total profit

102

40

145

104

103

If the firm were to produce the 104th unit, this last unit would cost more to produce than it earns in revenue (-105) this would reduce total profit and so would not be worth producing.
The profit maximising output is where MR = MC